A Simple Breakout Pattern Plan For Reducing Risk and Capturing Profit

Can you see the quiet before the storm in the market? Do you know the best way to take advantage of a pending breakout pattern? I’ve just worked on a simple plan that walks you through how to trade a straddle and strangle hybrid position that best reduces risk and captures profit for a pending breakout pattern.

I created this “Charts of Interest” video for my Trading Trainer ‘Learning Community’ program participants this past weekend, where I featured this passive breakout example. I showed how to validate the chart pattern we would trade against. I showed how to optimize the straddle and strangle hybrid position.

After reviewing the video, I knew I struck gold. My ‘Learning Community’ participants get this kind of information weekly. I walk them through a ‘Chart of Interest’ and give them a step-by-step plan that they can execute on, but this is a new plan for me and I knew it had to get out to a wider audience.

I’m excited for this simple plan and I know after you watch it you’ll see how it can quickly be implemented into your trading toolkit. Enjoy!

Video Transcription
Hi there. This is A.J. Brown with Trading Trainer on the afternoon of Sunday, July 8, with your Trading Trainer Daily Insights. What we’re going to do here is take a look at our Trading Trainer ‘Daily Picks’ report generation tool. We’re actually going to create for ourselves a pick list. From this pick list, we’re going to find a candidate, do a full analysis on it, see if it deserves to be on our hot list. If it does, we’re going to craft follow through rules, pick option trading strategies, preselect options, and put together preliminary exits.

Team, we’re gonna do actually a deeper dive on Lululemon (ticker LULU). $128.54, up 3.23%. $128.54 is a little bit overpriced. There is a volume imbalance, just fantastic. Now, Lululemon with the sharp chart shows consolidation maybe the 20-day exponential moving average (EMA) has a little bit of distance to come. Point and figure chart shows that we’re at some sort of top but kind of topping out. Not really any resistance above or below. Looking at a volatility graph… this is what I like, the implied volatility is so low compared to historical volatility.

Let’s pull up a chart. If I pull up a chart on Lululemon, what you can see is what we identified in our pending breakout. So if you remember our pending breakout, we had support and resistance at $124 and $129.75 respectively. So here’s $124. And here’s $129.75. And I’ll go to a three-month chart so you can see that a little bit better. I will switch it to candlesticks so you can really see it better.

We’re looking at this channel here. Again, this was our active set-up. But what about a passive set-up? Here’s our resistance $129.75. Here is our support at $124. Halfway between resistance and support is in the middle of the channel. At $126 and 7/8; $126.875.

Now I went ahead and used the Think or Swim tool and I looked up implied volatility because the implied volatility found here on the CBOE chart is for all of the calls and puts averaged out into the mean. I want to look at simply the series, in other words, the expiration dates of the options I’m interested in.

I’m interested in August and September. Now, again, Think or Swim has done a good job of measuring implied volatility and even the movement of said implied volatility. But again, that’s all of the options in that chain at that expiration date and I’m just interested really in the data points right around the middle of my identified trading channel. If I take for August, the implied volatilities, 28.99%, 27.60%, 27.98%, and 27%, and average those together do I get 29.19%? No, I get 27.9% as you can see here in my write up. 0.278925 to be exact.

And also I’ve decided to calculate it for September and as you can see here instead of the 39.91% shown by Think or Swim, we’re just taking the implied volatility around the channel center that we got. And we’re not too far off; 38.44%.

Let me show you something else that you can do. You can take a look at the product depth which is basically a volatility skew diagram and it’s showing us all of our strike prices and it’s showing them for all of the expiration dates. Now, generally, if there’s no big event coming, then your implied volatility should be a smooth curve in both directions as you can see here as we get further and further out with our August, September.

Our September hardly had any burp. Definitely, the near term had a big burp, but don’t forget that Vega on near-term options quickly goes to zero. A nice middle point is this August. We’re going to use the August implied volatility. I calculated 27.8925%. Think Or Swim is calculating it across the full spectrum of August at 29.19%. Again, either number. I like using my number, but it’s not going to change the standard deviation too much.

We take the square root of the number of days over 365. We can do that calculation right now, actually, so you can see how it comes out. If I take 40 divided by 365 days, and then take the square root of said number, multiply it by the implied volatility I calculated, 0.278925, (remember this is a decimal, not a percentage), multiplied by the center point of my channel, $126.875, I get $11 dollars and basically 71 or 72 cents. And so from that $11.72, I’m going to subtract and add it to my channel center. This is my probability curve analysis.

Coming out back to our chart, we want to look at basically one and two sigmas. $115 and $138 and see if we are overpriced or not. In other words, if we have a break, are we at a point here where we should be able to get passed that $115, which is all the way over here. That would be going passed this rising window here for those candlestick aficionados, or even higher.

$115 and then even $103, which is down here. If we crash, are we going to crash big? Because that’s what we would need to do because this is how much those August options are priced out. And it would have to happen before August expiration. Question is, is that going to go down? That’s something that we’re going to check for ourselves. The implied volatility would need to go up even higher for us to make any more money than this. This is already telling us that these are pretty high priced for our series of options.

With that said, if we decide to go in on this, we’d want to select a straddle or strangle with a bottom to its smile curve at $126.875. Now again, coming back to our option chain in August, we have strike prices of $130 and we have $125. So how do we get $126.875? Well, we’re going to have to do a hybrid because we want, again, the $126.875 to be right where we believe the middle point is.

And so our follow through rules and/or pre-selected options might be something like we have a straddle at $125 and that’s going to have the smile curve center point at $125. Then we’re going to have a strangle between $125 and $130. That’s going to have a center point of $127.50. And so what combination of the two do we need to get $126.875 or close?

If we can afford ten contracts, what I would say is we would probably want to do seven contracts of the strangle and then three contracts of the straddle. Let’s do the weighted average. $127.50 multiplied by seven, plus the straddles at $125, plus the $125, plus the $125, all divided by 10. We have a weighted average of $126.75. We’re looking to get it $126.875. You’d have to be able to afford 20 contracts in order to nail it down. Because then you would do something to the effect of 15 contracts out of 20. That lowest common denominator, in that case, is four contracts with three $125 | $130 strangles and one $125 straddle.

Our follow through rule is to enter hybrid trade of three strangles and one straddle when the price is at $126.875.

What that’s going to do is that’s going to set me up if there’s going to be an implied volatility increase above and beyond this 27.8925%, we’ll get an appreciation just on that alone. And, of course, if there’s any price action off that center point, we’ll have everything working for us.
That’s our follow through rules. It’s that easy. And then, our preliminary exit. Exit the straddle after profitable at reversals. Calls at tops and puts at bottoms. Once this thing is profitable and to your liking, usually it’s after some sort of either passive breakout or a jump in implied volatility, then you look for a top for the calls to get out and the bottoms to get out of the puts.

Pretty straightforward. This one has a lot of analysis up front and the one thing you really want to take a look at besides comparing our implied volatility to our historical volatility on the overall symbol is looking at the volatility skew graphs is definitely not a bad thing. Which is what we’ve got here. And looking at the probability curve the way that we calculated it with the center price and with the implied volatility as we calculated it. And going from there. Like I said, folks have already priced in a pretty good move down or up into the position and that’s what we’re going to have to see in the next 40 days. Is that possible? Well, it did it once before. It depends on how stagnant that you are. And could the anticipation of the next earnings, which we see here, looks to be pretty good. Could that anticipation get us going?

With that said, what I’d like you to do is take a look at our passive set-up compared to our active set-up. Take a look at our ‘follow through’ rules and preliminary exits.

That’s all I’ve got. Please take care.